ng of certain building materials costs in southern Florida shortly after Hurricane Andrew. All three of these systematic risks will be recognized as sources of performance variation. Interest rate riskThe real risk associated with insurance company investments lies not in an overexposure to volatile assets, but in their sensitivity to changing interest-rate conditions. Specifically, these risks relate to the impact of a sustained low interest-rate environment or sudden and unexpected jumps in interest rates. Both scenarios could lead to asset-liability mismatches; the latter could create significant liquidity pressures for some insurers. To hedge against interest-rate risk, many insurers make extensive use ofderivatives. While well-run derivatives programs are an appropriate means of managing risk, the events of 1998 have raised questions about systematic risk and illiquidity in this market.Currency riskAs financial markets become more integrated and international, the logic for seeking better yielding international investment opportunities becomes more compelling.Investing in a foreign security involves all the risks associated with investment in a domestic security but involves additional considerations and risks as well. The cash flows from international investments will be realised in a foreign currency. If the insurer expects claims in that currency, the investment will reduce the currency risk associated with policies whose claims are denominated in the foreign currency. If no such claims are expected, there is the possibility that exchange losses/gain could arise when investment cash flows are converted into domestic currency. Currency risk refers to uncertainty about the rate at which future foreign cash flows can be converted into the domestic currency. Currency risk can usually be hedged in the futures and options markets, although some believe that the transaction and maintenance costs may outweight the reduction in risk.Liqu...
